A Fiscal Fix? California's Dreamin'

Is the Golden State too big to fail?

California's governor and top financial leaders trekked to Washington last month to plead for federal help with their deficit mess. Their lobbying campaign sparked renewed efforts by other states and municipalities to obtain federal guarantees of municipal bonds, and revived hopes that House Financial Services Committee chair Barney Frank will move forward on a proposed bill reportedly in the drafting stages.

Following failure of the May 19 referendum votes on the legislature's proposed budget fix, Governor Arnold Schwarzenegger submitted a new fiscal plan with controversial budget cuts to the legislature, which must approve some of the measures under California legal system. If another political stalemate ensues, and the red ink continues, a genuine financial crisis looks even more likely.

California's financial distress is escalating, raising nervous concerns about the state's ability to keep rolling over its debt. Its doomsday scenario dwarfs the notorious problems of New York City in the 1970s, because this mess involves a sovereign state with constitutionally limited revenue powers -- and not a political subdivision of a state with broader authority in emergencies. California's political gridlock and Prop 13 constitutional limits on taxes makes it even more difficult to solve its deficit problems. Massive budget cuts appear to be inevitable. Voters soundly rejected an extension of tax increases and other measures that might have helped trim the growing budget deficit. They show no willingness to tax themselves more than the current deadly "double-double" combination of a 10 percent sales tax plus 10 percent income tax levels already facing many residents.

The state's political problem in Washington is that it's hard to win sympathy from members of Congress who represent states that have kept their fiscal houses in relatively good order despite the recession. Nobody wants to reward bad behavior, and California has set new records in that department by budgeting and spending money it didn't have, while blocking layoffs at the legislative level in a partisan game of budgetary "chicken."

On the other hand, the problems facing the tarnished Golden State are not unique in public finance. Federal stimulus relief has provided a fiscal Band-Aid for many states but is hardly enough to stanch the arterial bleeding in state budgets as tax revenues plummet amid rising unemployment. This year will be the first in decades in which total state and local government revenues actually decline; 2010 may be even worse, as tax revenues lag the economy. The municipal bond market remains fragile, as investors fear that Sacramento's problems will spread elsewhere before this economic malaise has ended.

Bankruptcy by the most populated state in the union is not an answer, nor is a megabillion-dollar default on the state's bonds, which would effectively freeze the municipal bond market and scare away institutional investors. The national recession would only deepen as state and local government infrastructure projects come to a halt despite federal stimulus efforts. All the Wall Street talk about "green shoots" of economic recovery will quickly fade, and this recession will become a "W" or an "L" and not a "V."

There are four ways that Congress can help California without making outright grants of federal dollars. As California's leaders already proposed, one option is to apply the Troubled Asset Relief Program (TARP) to include state governments. Some legal scholars believe the authority is already there, but the Obama Administration seems reluctant to take that path, and the remaining TARP funds may well be needed for their original purpose -- to prevent a banking crisis a la the Great Depression. Another option is for the federal government to guarantee California's bonds by a special Congressional act. That singles out one state and fails to build a lobbying coalition -- not likely to clear the Hill. Neither of these options seem likely to prevail.

A third path would be for Congress to establish a facility for federal bond insurance or guarantees of any qualifying state's or municipality's bonds, which is essentially what Representative Barney Frank's bill would provide. A fourth option, contained in Representative Gerald Connelly's bill (HR 1669), would be for Congress to provide state and local governments access to the Federal Financing Bank (FFB), with California leading the pack. These two solutions might be combined if a crisis scenario develops.

Federal guarantees of municipal bonds will immediately reduce the borrowing costs for issuers, and could reinstate AAA-rated tax-exempt paper which normally would be the cheapest way for a state to borrow. The problem right now is that highest-rated municipal bonds trade at interest rates above those of the taxable paper sold by the U.S. Treasury itself. So the traditional benefits of tax-exempt municipal finance are less compelling -- for California especially.

That's why the Federal Financing Bank proposal in Connelly's bill could actually be the most cost-efficient way to fund California's debt bridge. Using a 10-year workout period, for example, the Treasury could borrow money serially at 2 to 4 percent in today's market and re-lend at that same rate to California through the FFB. Unlike a tax-exempt bond issue which yields no revenue to Uncle Sam, California's lower-cost borrowing at FFB would require no tax subsidy as many of the underlying Treasury bond investors would pay income taxes. Keeping California's new debt out of the municipal market would also reduce total supply of tax-exempt bonds, which would benefit conventional muni rates for other states and municipalities. Finally, there is a broader global market for U.S. Treasury bonds than for debt of any state, even California.

In return for federal financial support, the Obama Administration and Congress need to formalize the restrictive terms and conditions they would impose on borrowers who gain access to these credit facilities. Given the sour mood of Americans over "Bailout Nation," a federal debt-market assistance bill for states and municipalities must attach some powerful "strings" that can be explained to constituents nationwide.

As proposed in my previous column on muni bond guarantees, there are several important requirements that should be built into a final bill. For starters, recipients of federal credit guarantees should be required to first obtain private insurance on their bonds and to establish debt service reserves and rainy day funds. I'm not sure any private bond insurer is strong enough to underwrite the entire risk in California's case, so it may be necessary to require co-insurance on large state deals and first-line insurance for the others. The important concept is to put private insurers at risk along with (and preferably ahead of) the federal taxpayers if a guaranteed issuer defaults. Federal taxpayers should only underwrite and subsidize risks that partnering private insurers are also willing to accept.

Other important statutory and contractual terms would help ensure that we don't face this problem again in a few years, as new revenues must be earmarked for the protection of U.S. taxpayers. If the funding is allowed through the FFB as described above, additional "loan terms" should be established just the way a banker would impose covenants on a corporate borrower. These could include statutory federal authority for FFB, the Treasury Secretary or a federal judge to require layoffs and furloughs, spending cuts, prohibitions against spending income tax receipts from capital gains for ongoing expenses, a requirement to properly fund its retiree medical and pension plans once revenues rebound, and similar bitter medicine to ensure that the borrower's budget actually gets rebalanced and stays that way.

The statutory authority for all these deals should include an enforceable contractual provision that a default by the recipient would disqualify it from receiving other federal aid. In the private sector, this is called an "offset" against other funds. Congress should also provide that if a borrower or issuer defaults on its federally assisted contractual obligations, it automatically enters federal receivership. This statutory and contractual requirement would empower the Treasury and Justice departments to go federal court to modify or even annul contracts and labor agreements if a state or municipal default puts federal taxpayers and the entire municipal bond market at risk.

As a California resident, I hardly relish the reductions in public services, living conditions and the quality of public education that these stern measures would imply. But the federal alternative of "let them eat cake" is even gloomier. Downsizing is inevitable under every imaginable scenario, so let's trim sail and chart a sustainable course. If any state or political subdivision receives federal assistance, mainstream Americans will expect the conditions to be sufficiently austere to deter a repeat performance or a stampede of tag-along borrowers. Sacramento's elected leaders deserve tough love. Otherwise the floodgates will open and we're back to the moral hazards of Bailout Nation, which is what the Obama team now fears if they appear to be too lenient.

A federal backstop credit facility -- with painful, powerful strings attached -- may be the state's destiny, and a backstop for other struggling states and subdivisions. Careful crafting will help us avoid a doomsday scenario in which a collapsing-giant state economy threatens the nation at large. Let's not forget that we call ourselves the United States, before California falls off into an ocean of its own red ink.